Does austerity promote economic growth?

A study of countries that implemented 'austerity plans' showed they often weaken the economy [GALLO/GETTY]

New Haven, Connecticut - In his classicFable of the Bees: or, Private Vices, Publick Benefits (1724), Bernard Mandeville, the Dutch-born British philosopher and satirist, described - in verse - a prosperous society (of bees) that suddenly chose to make a virtue of austerity, dropping all excess expenditure and extravagant consumption. What then happened?

The Price of Land and Houses falls;

Mirac'lous Palaces, whose Walls,

Like those of Thebes, were rais'd by Play

Are to be let; . . .

The building Trade is quite destroy'd

Artificers are not employ'd; . . .

Those, that remain'd, grown temp'rate strive

Not how to spend, but how to live . . .

That sounds a lot like what many advanced countries have been going through, after financial-crisis-induced austerity plans were launched, doesn't it? Is Mandeville a genuine prophet for our times?

Fable of the Bees developed a wide following, and generated substantial controversy, which continues to this day. The austerity plans being adopted by governments in much of Europe and elsewhere around the world, and the curtailment of consumption expenditure by individuals as well, threaten to produce a global recession.

But how do we know if Mandeville is right about austerity? His research method - a long poem about his theory - is hardly convincing to modern ears.

Austerity: good or bad?

Harvard economist Alberto Alesina recently summarised [PDF] evidence concerning whether government deficit reduction - that is, expenditure cuts and/or tax increases - always induces such negative effects: "The answer to this question is a loud no." Sometimes, even often, economies prosper nicely after the government's deficit is sharply reduced. Sometimes, just maybe, the austerity program boosts confidence in such a way as to ignite a recovery.

We have to examine the issue with some care, understanding that the issue that Mandeville raised is really a statistical one: the outcome of government deficit reduction is never entirely predictable, so we can ask only how likely such a plan is to succeed in restoring economic prosperity. And the biggest problem here is accounting for possible reverse causality.

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For example, if evidence of future economic strength makes a government worry about economic overheating and inflation, it might try to cool domestic demand by raising taxes and lowering government spending. If the government is only partly successful in preventing economic overheating, it might nonetheless appear to casual observers that austerity actually strengthened the economy.

Likewise, the government's deficit might fall not because of austerity, but because the stock market's anticipation of economic growth fuels higher revenues from capital-gains tax. Once again, we would see what might appear, from looking at the government deficit, to be an austerity-to-prosperity scenario.

Jaime Guajardo, Daniel Leigh, and Andrea Pescatori of the International Monetary Fund recently studied austerity plans implemented by governments in 17 countries in the past 30 years. But their approach differed from that of previous researchers. They focused on the government's intent, and looked at what officials actually said, not just at the pattern of public debt. They read budget speeches, reviewed stability programs, and even watched news interviews with government figures. They identified as austerity plans only those cases in which governments imposed tax hikes or spending cuts because they viewed it as a prudent policy with potential long-term benefits, not because they were responding to the short-term economic outlook and sought to reduce the risk of overheating.

Their analysis found a clear tendency for austerity programs to reduce consumption expenditure and weaken the economy. That conclusion, if valid, stands as a stern warning to policymakers today.

'Likely to yield disappointing results'

But critics, such as Valerie Ramey of the University of California at San Diego, think that Guajardo, Leigh and Pescatori have not completely proven their case. It is possible, Ramey argues, that their results could reflect a different sort of reverse causality - if governments are more likely to respond to high public-debt levels with austerity programs when they have reason to believe that economic conditions could make the debt burden especially worrisome.

That may seem unlikely - one would think that a bad economic outlook would incline governments to postpone, rather than accelerate, austerity measures. And, in response to her comments, the authors did try to account for the severity of the government's debt problem as perceived by the markets at the time that the plans were implemented, finding very similar results. But Ramey could be right. One would then find that government spending cuts or tax hikes tend to be followed by bad economic times, even if the causality runs the other way.

Ultimately, the problem of judging austerity programs is that economists cannot run fully controlled experiments. When researchers tested Prozac on depressed patients, they divided their subjects randomly into control and experimental groups, and conducted many trials. We cannot do that with national debt.

So do we have to conclude that historical analysis teaches us no useful lessons? Do we have to return to the abstract reasoning of Mandeville and some of his successors, including John Maynard Keynes, who thought that there were reasons to expect that austerity would produce depressions?

There is no abstract theory that can predict how people will react to an austerity program. We have no alternative but to look at the historical evidence. And the evidence of Guajardo and his co-authors does show that deliberate government decisions to adopt austerity programs have tended to be followed by hard times.

Policymakers cannot afford to wait decades for economists to figure out a definitive answer, which may never be found at all. But, judging by the evidence that we have, austerity programs in Europe and elsewhere appear likely to yield disappointing results.

Robert Shiller, Professor of Economics at Yale University, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.